When a small business incorporates, it is automatically a C corporation, also called a regular corporation. The most basic characteristic of the corporation is that it is legally viewed as an individual entity, separate from its owners, who are now shareholders. This means that when the corporation is sued, shareholders are only liable to the extent of their investments in the corporation. Their personal assets are not on the line, as they would be if the business was a partnership or sole proprietorship. Any debts that the corporation may acquire are also viewed as the corporation's responsibility. In other words, once the business is incorporated, shareholders are protected by the corporate veil, or limited liability.
Because the corporation is a separate entity, it is viewed as an individual taxpayer by the Internal Revenue Service (IRS). As a result, corporations are subject to double taxation, which means that the profits are taxed once on the corporate level and a second time when they are distributed as dividends to the shareholders. If a business is eligible, it may elect S corporation status upon incorporating to avoid this negative characteristic of C corporations.
Most small businesses that consider incorporating do so for the limited liability that corporate status affords. The greatest fear of the sole proprietor or partner—that his or her life's savings could be jeopardized by a law suit against his or her business or by sudden overwhelming debts—disappears once the business becomes a corporation. Although the shareholders are liable up to the amount they have invested in the corporation, their personal assets cannot be touched. Rather than purchase expensive liability insurance, then, many small business owners choose to incorporate to protect themselves.
It can be much easier for a corporation to raise capital than it is for a partnership or sole proprietorship, because the corporation has stocks to sell. Investors can be lured with the prospect of dividends if the corporation makes a profit, avoiding the necessity of taking out loans and paying high interest rates in order to secure capital. However, from a banker's perspective, a newly formed corporation is a more risky loan applicant than an individual with a home and other assets.
Attracting Top-Notch Employees
Corporations may find it easier to attract the best employees, who may be lured by stock options and fringe benefits.
One advantage C corporations have over unincorporated businesses and S corporations is that they may deduct fringe benefits (such as group term life insurance, health and disability insurance, death benefits payments to $5,000, and employee medical expenses not paid by insurance) from their taxes as a business expense. In addition, shareholder-employees are exempt from paying taxes on the fringe benefits they receive. To be eligible for this tax break the corporation must not design a plan that benefits only the shareholders/owners. A good portion of the employees (usually 70 percent) must also be able to take advantage of the benefits. For many small businesses, providing fringe benefits for all employees is too expensive, so in these cases the tax break is not a particular advantage.
Continuance of Existence
Transfer of stock or death of an owner does not alter the corporation, which exists perpetually, regardless of owners, until it is dissolved. While this is usually considered an advantage, Fred Steingold argues in The Legal Guide for Starting and Running a Small Business that, in reality, "You don't need to incorporate to ensure that your business will continue after your death. A sole proprietor can use a living trust or will to transfer the business to heirs. Partners frequently have insurance-funded buy-sell agreements that allow the remaining partners to continue the business."
After they deduct all business expenses, such as salaries, fringe benefits, and interest payments, C corporations pay a tax on their profits at the corporate level. If any of those profits are then distributed as dividends to the shareholders, those individuals must also pay a tax on the money when they file their personal tax returns. For companies that expect to reinvest much of the profits back into the business, double taxation may not affect them enough to be a serious drawback. In the case of the small business, most if not all of the company's profits are used to pay salaries and fringe benefits, which are deductible, and double taxation may be avoided because no money is left over for distributing dividends.
Bureaucracy and Expense
Corporations are governed by state and federal statutes. In order to abide by all of the sometimes complex regulations related to C corporations, it is often necessary to hire lawyers and accountants to assist with tax preparation. Regular stockholder and board of directors meetings must be held and detailed minutes of those meetings must be kept. All of the actions taken by a corporation are to be approved by its directors and this necessity can reduce a company's ability to take quick action on pressing matters. Another difference between a sole proprietor and a C corporation that imposes a bureaucratic burden arises if and when a corporation wishes to bring a case in small claims court. The corporation is required to be represented by a lawyer, whereas sole proprietors or partners can represent themselves. In addition, if the corporation does interstate business, it is subject to taxes in other states.
Rules Governing Dividend Distribution
A corporation's profits are divided on the basis of stockholdings, whereas a partnership may divide its profits on the basis of capital investment or employment in the firm. In other words, if a stockholder owns 10 percent of the corporation's stock, she may only receive 10 percent of the profits. However, if that same person was a partner in an unincorporated firm to which she had contributed 10 percent of the company's capital, she might be eligible to receive more than 10 percent of the business's profits if such an agreement had been made with the other partners. Strict rules, though, govern the way corporations divide their profits, even to the point, in some states, of determining how much can be distributed in dividends. Usually, all past operations must be paid for before a dividend can be declared by the corporation's directors. If this is not done, and the corporation's financial stability is put in jeopardy by the payment of dividends, the directors can, in most states, be held personally liable to creditors.
STRUCTURE OF A CORPORATION
In small businesses, the owners often hold more than one or all of the following positions, which are required of all corporations:
- Shareholders: They own the company's stock and are responsible for electing the directors, amending the bylaws and articles of incorporation, and approving major actions taken by the corporation like mergers and the sale of corporate assets. They alone are allowed to dissolve the corporation.
- Directors: They manage the corporation and are responsible for issuing stock, electing officers, and making the corporation's major decisions.
- Officers: The corporation must have a president, secretary, and treasurer. These officers are responsible for making the day-to-day decisions that govern the corporation's operation.
- Employees: They receive a salary in return for their work for the corporation.
FINANCING A CORPORATION
Financing the operations of a corporation may involve selling stock (equity financing), taking out loans (debt financing), or reinvesting profits for growth.
This is cash, property, or services exchanged for stock in the company. Generally, each stock is equivalent to one dollar of investment. If the small business owner is planning to exchange property to the corporation for stock, then a tax advisor should be consulted; if the property has appreciated, taxes may be due on the exchange.
This is money lent by banks or shareholders. In the former case, a personal guarantee by the corporation's principals is usually required, which makes an exception to the limited liability rule. The owner of a corporation who personally guarantees a loan is also personally responsible for paying it back if the corporation goes under. Many corporations have preferred to fund the corporation with shareholder money in exchange for promissory notes because unlike dividends, the repayment of debts is not taxable. The Internal Revenue Service monitors such debt closely, though, to make sure it is not excessive and that adequate interest is paid. It should be noted that the interest accrued on money borrowed is taxable when paid to the lender.
PAYING C CORPORATION TAXES
After the C corporation deducts all business expenses, such as salaries, fringe benefits, and interest payments, it pays a tax on its profits at the corporate level. Then dividends may be distributed to the shareholders who must pay a tax on the money when they file their personal tax returns. In the case of the small business, though, double taxation may not be a consideration, because most, if not all of the company's profits are reinvested in the business or go to pay salaries and fringe benefits, which are deductible, and no money is left over for distributing dividends.
To avoid double taxation, corporations sometimes pay their shareholder-employees higher salaries instead of distributing income as dividends. The IRS, however, watches out for such tax avoidance measures and often audits corporations, claiming that executive salaries are not "reasonable" compensation. To prevent this charge, then, the corporation should consider the duties performed, the experience and/or special abilities of the employee, and how much other corporations pay for similar positions before determining "reasonable" compensation. A corporation should keep salaries somewhat consistent over time as fluctuating salaries—high salaries in high earning years and low salaries in lean years—will attract a review of salary payments by the Internal Revenue Service. A charge might be made, for example, that the high salary payments were in fact dividend payments.
RUNNING A CORPORATION
Once a small business has been incorporated, the day-today management of business affairs should not be that much different than it was beforehand. It is important, though, that the business is treated like a corporation. The courts have been known on occasion to overlook a business's corporate status and find the shareholders/owners liable because the business was run as if it were still a sole proprietorship or partnership. Simply filing the articles of incorporation does not guarantee limited liability. In order to maintain corporate status in the law's eyes, these guidelines should be followed:
Act Like a Corporation Before doing business, stock certificates should be issued to all stockholders, and a corporate record book should be established to hold the articles of incorporation, records of stock holdings, the corporation's bylaws, and the minutes of board and shareholder meetings. In addition, such meetings should be held regularly (once a year is the minimum requirement). In this way, the corporation can record all important actions taken and show that such actions were approved by a vote. It is also important to treat the corporation like the separate entity it is by keeping personal and corporate accounts separate. Whereas a small business owner may have previously used one account to pay the company's accounts and personal expenses, as a corporate shareholder, he now needs to receive a regular salary from the corporation, deposit it in a separate account, and pay his personal expenses from that account. In all respects, the corporation and owner must be treated as distinct individuals. Fred Steingold advises, "document all transactions as if you were strangers. If the corporation leases property to you, sign a lease." In addition, the corporation's full name (which should indicate the company's corporate status through use of "Inc." or an equivalent) must be used on all correspondence, stationery, advertising, phone listings, and signs.
Act Like a Corporate Officer When the corporation's owner signs her name to checks, contracts, or correspondence for the corporation, she must always indicate that she is the president to show that she is not acting on her own but as an agent of the corporation.
Adequate Capital Investment and Insurance Coverage It is important to protect the corporation against failure due to debts and lawsuits. In other words, simply trying to protect the owners' assets by becoming a corporation and neglecting to fortify the business can be viewed as reason to disregard a business's corporate status in a lawsuit. Therefore, enough capital should be invested in the corporation to handle all business activities. Likewise, if business activities pose a risk to employees or customers and reasonably priced insurance is available to protect against such risks, such coverage should be secured.
see also Incorporation; S Corporation
Byrd, Stephen, and Brett Richey. "The Choice of Entity for the Small Business Owner." Mid-Atlantic Journal of Business. 1 December 1998.
Cornwall, Dr. Jeffrey R., David Vang, and Jean Hartman. Entrepreneurial Financial Management. Prentice Hall, 13 May 2003.
Epstein, Lita. Reading Financial Reports for Dummies. December 2004.
"New Ventures and Start-Ups: Which Form of Business Is Best for You?" Business Owner. January-February 1999.
Selecting the Legal Structure for Your Business. Small Business Administration. n.d.
Steingold, Fred S. The Legal Guide for Starting and Running a Small Business Fifth Edition. Nolo Press, 2005.
Taylor, Peter. Book-Keeping & Accounting for Small Business. Business & Economics, 2003.
Hillstrom, Northern Lights
updated by Magee, ECDI